Journal article

Capacity investment, production flexibility and capital structure

Publication Details

Author list: Peter Ritchken, Qi Wu.

Publisher: Wiley: 24 months

Publication year: 2020

Journal: Production and Operations Management

Volume number: Special

Start page: 1

End page: 39

Total number of pages: 39

ISSN: 1059-1478

eISSN: 1937-5956



Many manufacturing firms have become increasingly flexible in that they can rapidly idle and
restart pro- duction in response to changing commodity prices. We study how operational
flexibility alters both the timing and financing decisions in the firm. We perform this analysis
in a dynamic model in which a firm has multiple debt issues and decisions are made to maximize
shareholder value. We compare the decisions of a flexible firm, which can temporarily shut down to
avoid operational losses, with those of a rigid firm which is not able to stop operating even in
states where operational losses occur. On one hand, firms with oper- ational flexibility can better
exploit a larger tax shield by taking on more debt. On the other hand, taking on more debt may be
less harmful for a rigid firm, since it increases the default threshold thereby reducing the region
where operational losses are experienced due to inflexibility. We explore how the two forces trade
off between the benefit of tax shield and the cost of default. We find that, even though
bondholders charge a higher fair premium for debt issued by the inflexible firm, the rigid firm
will utilize more debt. We also show that, all things being equal, firms with operational
flexibility invest earlier and use less debt to finance the opportunity. Dynamic models that trade
off tax shields with bankruptcy costs and ignore operational flexibility may result in theoretical
leverage ratios being biased high.

Key words : asset flexibility; commodity prices; capital structure; profitability; growth options
History : Received: September 2019; accepted: July 2020 by Nicola Secomandi after two revisions.


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